In a business-as-usual scenario, it appears the dollar will remain at weaker levels in the coming months.
The US Federal Reserve’s rate hike cycle commenced in December 2015 after rates being near-zero for seven years (since 2008). Theoretically, the dollar rises in tandem with increasing interest rates. To add to that, the optimism around the US elections and positive data helped the US Dollar Index (USDX) reach a level of 103—a 13-year high—last year. Cut to 2017, despite the (two) Fed rate hikes, the USDX has been weakening and touched a multi-month low in September. Given the strong sentiment on the euro and talks of a QE tapering, coupled with political uncertainty in the US, will the weak dollar story continue for long? And will the current pace of US recovery warrant another 25bps rate hike, as projected?
Current trend of the USDX
The USDX is a geometrically-averaged calculation of six currencies—euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%)—to provide an external bilateral trade-weighted average value of the US dollar. The dollar is currently weaker by 3.8% compared to the same period a year ago, and by 10.5% since the start of 2017, at 91.99. Within the span of a month, the dollar saw a steady depreciation from 94 to 91. The dollar was last seen around the current levels in January 2015 before moving up due to events such as the UK referendum and optimism around the US elections. Most emerging market currencies have mirrored the trend in 2017 and strengthened against the dollar. Some currencies in particular, such as the Indian rupee, Thai baht and Taiwan dollar, gained the most. The rupee rose by 6% to 64.12 since January 2017, also supported by optimism over domestic reforms such as GST, Bankruptcy Code and strengthening political stability. The move up in most currencies has been especially due to weakening dollar. But the euro’s appreciation can be also credited to the improving domestic fundamentals and the dilution of political risks surrounding the elections. The euro has appreciated by 13% to 1.19 since January 2017. Markets have been more bullish about the euro following talks about the tapering of the bond-buying programme of 60 billion euros a month.
What drives the dollar?
The following is a summary of analysis of long-term charts that plotted the USDX against its theoretical underpinnings:
1. Global risk appetite: It is typically believed that the USDX strengthens in phases of risk aversion (i.e. low risk appetite or increasing fear in financial markets) as funds move towards dollar assets that are regarded relatively safe. Long-term charts show that risk appetite indexes typically have a negative relationship with the USDX. Both the commodities market and emerging market currencies exhibit such negative relationship, but that can be a two-way relationship rather than a cause-effect one. Since the start of 2017, the MSCI Emerging Markets Index rose by about 17% till date, while the USDX fell by 6.8%. The relationship appears to be stable in the short as well as the long run. When the VIX Index (measures the level of volatility in the market) moves up, the USDX typically appreciates, but not always. In the recent six months too, the relationship showed small positive correlation. On the other hand, the relationship of the USDX with the US stock market has been weak and less reliable. The long-term data shows a weak positive correlation, possibly reflecting the long-term increase in both US stock markets and USDX post the recent financial crisis period. Interestingly, in recent times, despite a continued fall in the USDX, the stock market continued to inch up.
2. Interest rate differential with the euro: The euro has the highest weightage in the USDX basket. Over a longer term, it is seen that whenever interest rate differential between the US and Europe shrinks, the euro strengthens. This is truer when the interest rate differential is seen in terms of sovereign yields rather than policy rates. Recently, the yield differential has fallen despite the increase in policy rates in the US. That is because of the fact that US yields have softened, reflecting the increased uncertainty over future rate hikes in the US, whereas European yields have softened to a lower extent.
3. Inflation differential with the euro: Long-term charts show the inflation differential between the US and Europe is not strongly related with currency movement.
4. Fed funds rate: Theoretically, the dollar rises in tandem with rising interest rates in the US. But there have been cases in the past where this relationship was reversed. In recent two rate hikes of 25bps each, the dollar fell as the market had already factored in the hikes. The Fed has projected another 25bps rate hike in 2017, but that also may be largely factored in despite being data dependent. Markets are expected to react more to any delays in Fed’s normalisation. Recently, there have been a number of factors that have led to the dollar weakening.
• The incoming data from US economy has been weak. The Fed raised rates in its June meeting despite subdued inflation reading for 2-3 consecutive months and low Q1-2017 GDP growth, which put pressure on the dollar. The dollar recovered partially in intervals, but did little to pare the currency’s lingering weakness over the past few months due to continued difficulties in pushing pro-growth reforms through Congress, which slowed the economic momentum.
• Globally, central banks with near-zero or negative rates, such as the European Central Bank (ECB) and Bank of England, have hinted at commencing monetary tightening cycle. Markets have been bullish about the euro of late, following the dilution of political risks around European elections and recent talks of the ECB reducing its 60 billion euro a month bond-buying programme (QE). Business cycle indicators in developed economies are largely in an upswing, which have led to a robust risk appetite in financial markets (reflected in equity valuations, metal prices).
• The Real Effective Exchange Rate (REER) of the dollar shows a state of overvaluation. The current REER of the dollar is 10% above the last five years’ average and thus overvalued in a historical sense. Mirroring the trend of the USDX, the REER Index has been inching downwards since February 2017. Overall, the current momentum of the USDX seems to be towards a further weakening in the short term. There are concerns on whether the approval of the US budget for FY2018 will be smooth sailing. Any delay in decision with regards to government spending could mean a greater risk of government shut down, which could be detrimental to the dollar. Continued improvement in global growth indicators support the risk appetite in financial markets. For these reasons, the Fed had projected another rate hike of 25bps in 2017, which was largely factored in by the markets. However, it may put brakes on raising interest rates again this year, primarily due to domestic fundamentals and weak progress towards its inflation target. According to Bloomberg, there is only a 28% probability assigned to a rate hike in December 2017. Thus, in a business-as-usual scenario, the dollar appears to be set to remain at weaker levels in the coming months. A one-time tax repatriation of past profits can boost the dollar, but the probability of such a tax measure getting approved appears extremely bleak in the current political scenario. Therefore, the only upside risk to the USDX could stem from any of the potential global risk events—like intensification of geopolitical tensions or resumption of anti-euro events. Until any such risk event, the dollar weakness is likely to continue.